Abstract

This article develops a “real options” approach for planning new water resources infrastructure investments and their operating strategies in a world of climate change uncertainty. The approach is illustrated with an example: investments in large new multipurpose dam alternatives along the Blue Nile in Ethiopia. The approach incorporates flexibility in design and operating decisions – the selection, sizing, and sequencing of new dams, and reservoir operating rules. The analysis relies on a simulation model that includes linkages between climate change and system hydrology, and tests the sensitivity of the economic outcomes of investments in new dams to climate change and other uncertainties. Not surprisingly, the results for the Blue Nile basin show that there is no single investment plan that performs best across a range of plausible future climate conditions. The value of the real options framework is that it can be used to identify dam configurations that are both robust to poor outcomes and sufficiently flexible to capture high upside benefits if favorable future climate and hydrological conditions arise. The real options approach could be extended to explore design and operating features of development and adaptation projects other than dams.